Why bonds defied expectations in the first 2 months of 2014

Market Realist

Do mortgage rates follow movements in Treasury yields? (Part 7 of 9)

(Continued from Part 6)

Bond markets

Bonds have made significant price gains in 2014, contrary to market expectations, which had anticipated a bear market in 2014 due to the onset of the Fed taper. The US Federal Reserve reduced its monthly purchases of longer-term Treasuries and agency-backed securities by $10 billion each in December 2013 and January 2014, and most recently on March 19, 2014, to $55 billion currently. The reduced liquidity brought on by the taper was expected to lower bond prices and raise interest rates. Instead, we saw a contrarian phenomenon. Bond prices rallied and yields dropped in the first two months of 2014.

The Vanguard Total Bond Market ETF (BND) and the iShares 10-20 Year Treasury Bond ETF (TLH) have increased by 2% and 4.6%, respectively, from January 1 to February 28 2014. The first ETF tracks the Barclays Capital US Aggregate Bond Market Index, which measures the performance of the U.S. investment-grade bond market. The iShares 10-20 Year Treasury Bond ETF (TLH) tracks the Barclays Capital 10-20 year US Treasury Bond Index, which measures the performance of U.S. Treasury securities that have a remaining maturity of at least ten years and less than 20 years.

Why have bond markets rallied in January and February 2014?

First, January and February have seen strong inflows into U.S. debt markets, as there was a flight-to-quality from emerging markets following the Fed’s contraction in economic stimulus, which overrode bearish expectations arising from the taper.

Second, investors remain skeptical that economic data releases have been influenced by unusually cold weather patterns (see the Market Realist series Has weather clouded readings on this week’s important releases?) and have chosen Treasuries as their safest bet in case the supposed weather influence masks a deceleration in the pace of economic recovery.

Investor appetite for Treasuries remains strong. The bid-to-cover ratios for Treasury auctions held this year have mostly surpassed expectations—especially the number of bids from non-dealers.

The price gain for TLT from January 1 to March 18 was ~6.3%. Prices dropped ~0.8% on March 19 on the Fed’s third taper announcement. A continuing taper would imply that the economy is recovering, which is expected to especially benefit stocks in the consumer cyclical space. The State Street Consumer Discretionary Select Sector SPDR ETF (XLY) is one ETF investing in the consumer cyclical sector. The ETF tracks the Consumer Discretionary Select Sector Index, which includes companies from the retail, media, hotel, restaurant, leisure, household durables, textile, apparel, and luxury industries. The top holdings in the ETF include Amazon (AMZN) and Walt Disney Co. (DIS).

To learn more about how Treasury rates and mortgage rates have moved together, read on to Part 8 of this series.

Continue to Part 8

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